12 augustus 2006

The US Department of Theasury has come out with a remarkable report. It studies the effects of making the tax breaks permanent, rather than letting them expire in 2010. The result, of course, would be a healthier and growing economy. The surprise is that the report also argues for financing the tax relief by cutting government spending and not by raising taxes elsewhere. Surprising, but logical.

Executive SummaryThis Report presents a detailed description of Treasury’s dynamic analysis of the President’s proposal to permanently extend the tax relief provisions enacted in 2001 and 2003 that are currently set to expire at the end of 2010. These enacted provisions include:

The purpose of the report is to provide a more in-depth, transparent understanding of dynamic analysis, while also illustrating the positive contributions the tax relief, together with spending reductions, can be expected to continue to make to the U.S. economy. In addition, the analysis shows the importance of making the tax provisions permanent for the U.S. economy’s long-term economic growth.

Dynamic AnalysisDynamic analysis goes beyond traditional analysis of tax policy by focusing on the broad economic effects in both the short and long term. Simply, dynamic analysis provides a more comprehensive and complete approach to analyzing tax policy by including its effects on the overall size of the economy and other major macroeconomic variables. The President’s FY 2007 Budget proposes to create a division of dynamic analysis within the Department of Treasury’s Office of Tax Analysis.

The Economic Benefits of Tax ReliefAs evidenced by key economic indicators such as increased capital investment and Gross Domestic Product (GDP), and strong job growth, the President’s tax relief played an important role in strengthening the U.S. economy as it was coming out of the recent recession, and in the longer-term by increasing the after-tax rewards to work and saving. Lower tax rates enable workers to keep more of their earnings, which increases work effort and labor force participation. The lower tax rates also enable innovative and risk-taking entrepreneurs to keep more of what they earn, which further encourages their entrepreneurial activity. The lower tax rates on dividends and capital gains lower the cost of equity capital and reduce the tax biases against dividend payment, equity finance, and investment in the corporate sector. All of these policies increase incentives to work, save, and invest by reducing the distorting effects of taxes.Capital investment and labor productivity will thus be higher, which means higher output and living standards in the long run. Treasury has conducted its dynamic analysis using a model that accounts for the effects of this greater work effort, increase in savings and investment, and improved allocation of resources on the size of the economy. While this model captures many aspects of a modern economy and economic behavior, others are not reflected in the model. For example, the model assumes that resources are fully employed in the economy and that capital is only somewhat mobile internationally. These are areas for future development.

Different Components of Tax Relief Have Different Effects on the EconomyTreasury’s dynamic analysis of the President’s tax relief indicates that making the tax relief permanent can be expected to increase the level of annual output (i.e., national income) ultimately by about 0.7 percent. The analysis also shows separately the effects of the President’s tax relief in three parts reflecting:1) the lower tax rates on dividends and capital gains;2) the lower tax rates on ordinary income (i.e., the top four rate brackets); and3) the 10-percent tax rate bracket, higher child tax credit, and marriage penalty relief. This decomposition reveals thatthese tax relief components are likely to have very different effects on future economic activity.For example, extending just the lower tax rates on dividends and capital gains increases output in the long run by 0.4 percent, but when the lower tax rates for the four top income tax brackets are extended as well, output increases by a total of 1.1 percent in the long run.Financing Tax Relief – Government Spending Reductions over Increased Tax RatesThe analysis reveals that the long-run effects of these policies depend crucially on whether they are financed by lower spending or higher taxes in the future and are sensitive to assumptions on underlying parameters. The issue of how, or even if, these policies need to be financed remains a source of discussion among economists. The analysis presented here suggests these policies will result in substantially more economic activity if they are financed by a future reduction in government spending than if they are financed by future tax increases. If the tax relief is financed by future tax increases – that is, if the aggregate amount of tax relief is temporary – then it may result in lower output in the long run. For that reason, the Administration has emphasized permanence for the tax relief and spending restraint in its Budgets.060725_Treasury_Tax_Cuts.pdf full report.